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Engineering Economics

XI-Sensitivity and Breakeven Analysis


Date:04/12/2017

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Sensitivity Analysis

Breakeven Analysis

Outcome of Todays Lecture


Demonstrate a basic level understanding of sensitivity and
breakeven analyses and the use of these tools in an
engineering economic analysis.

Objective
To illustrate sensitivity and breakeven methods for
investigating variability in outcome of engineering projects.
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Part I

Sensitivity Analysis

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To this point we have assumed a high degree of
confidence in estimated values.

The degree of confidence is sometimes called


assumed certainty, and decisions made on the basis of
this kind of analysis are called decisions under
certainty.
In virtually all situations, ultimate economic results
are unknown.
Breakeven and sensitivity analysis are used to help
understand how our decision might be affected if
our original estimates are incorrect.
Sensitivity Analysis

The sensitivity analysis, as such, aims to check if


the economic decision changes as one or more
of the data used change such as the MARR,
service life, annual maintenance cost, etc. This
section is dedicated to show how the change of
these values may change the economic decisions.
Sensitivity Analysis

To perform sensitivity analysis, follows the following steps:


Identify the factors(s) that values may change than that
has/have been identified.
Identify the range of values change for this/these factor(s).
Identify the economic decision criterion (e.g. NPW,
EUAW, IRR, etc.) that will be used to perform the
economic analysis.
Calculate the values of this economic criterion at different
levels of the changeable factor.
Draw a diagram for the obtained results from the previous
step to study the effect of these changes on the economic
criterion under study.
Example 1

The purchasing cost of a given equipment is


LE90,000 and its return for the first year is
LE30,000 decreasing annually by LE3,000. If the
investment rate changes between 10% and 25%
and the equipment age ranges from 8 to 12
years. It is required to study the sensitivity of the
decision considering the effect of the change of
the investment rate and the age using the
EUAW method. Neglect the equipment salvage
value.
Example 1
Example 1

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Example 1

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Example 2

A test vehicle has a cost of LE100,000 with a life of


10 years. Additional revenues of LE17,500 per year
are expected and the required MARR is 15%. If the
additional revenues are only estimates and might
fluctuate 15%. Evaluate the sensitivity of the
analysis.
Example 2
Example 2

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Example 3

A company wants to purchase a new core driller for


information gathering. It is expected that the machine
can be purchased for LE275,000 it will last 8 years,
expenses will total LE50,000 per year and that the
revenues will be LE100,000 per year. The company
requires a MARR of 10%.

a. Determine the sensitivity of the present worth to a


change in the MARR.
b. What would be the effects of a 10% range to all other
parameters?
Example 3

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Example 3
Example 3
Example 4: from Park
Example 4
Part II

Breakeven Analysis
Breakeven Analysis

A fundamental of accounting is that all revenues and


costs must be accounted for and the difference
between the revenues and costs is the profit, or loss, of
the business.

We know that Costs can be classified as either a fixed


cost or a variable cost.
Breakeven Analysis

A fixed cost is one that is independent of the level of sales;


rather, it is related to the passage of time.
Examples of fixed costs include rent, salaries and insurance.

A variable cost is one that is directly related to the level of


sales, such as cost of goods sold and commissions.
In planning and managing your business it is important to
know what level of sales must be achieved in order to meet
total costs. Every LE of sales above this will contribute to
profits.
Breakeven Analysis

Advantages of Break-even Analysis:

- It is simple to conduct and understand.


- It shows profit and loss at different levels of output.
- It can cope with changing circumstances, e.g. the
following changes in the business environment can be
shown in a break even chart.
Breakeven Analysis

Disadvantages of Break-even Analysis:


- It assumes that all output is sold at the given price (this may well
be untrue).
- Although it can cope with changes in circumstances, these factors
change regularly reducing its usefulness as a forecasting tool.
- The model assumes that costs increase constantly and do not
benefit from economies of scale. If the firm obtains purchasing
economies of scale then its total cost line will no longer be
straight.
- Break-even analysis is only as good as the data upon which it is
based. Poor quality data will lead to inaccurate conclusions being
drawn.
Example 4

A factory produces concrete blocks units. Each unit sells


for LE15 and costs LE5. The annual maintenance and
operation costs are LE75,000. Calculate the number of
blocks that should be produced to justify keep this
business running.
Example 4
Example 5
Breakeven Analysis

In case of evaluating alternatives using the breakeven analysis, the


breakeven point represents the point at which the total cost for
alternatives are equal considering that all alternatives have equal
revenue. In case of having alternatives with different revenues, the
breakeven for each alternative is identified first, then the breakeven
between each two alternatives is identified as follows:
Identify the common criterion (IRR, NPW, etc.) among
alternatives.
Calculate the cost in one of these criteria.
For each two alternatives, find the value at which the two
alternatives have equal cost.
Represent the results graphically and compare between
alternatives on the breakeven point.
Example 6

There are two proposals to buy a new production line


for brick manufacturing. The information related to both
alternatives is shown in the following table. If the interest
rate is 10%, find:

a. The volume of production that justifies the purchase of


Alternative A.

b. If the demand on the production of this factory is 2000


ton annually, which alternative do you recommend for
purchasing?
Example 6
Example 6
Example 6
Example 7

It is required to calculate the breakeven point for the


three options listed in the table below. Which alternative
do you recommend?
Example 7
Example 7
Example 7

To find the points of intersection, you may solve each


two equations together or you may find it from the
graph shown above. The above shows the following:

- If the production is less than 4000 units, then


alternative A is the best.
- If the production is greater than 4000 and less than
5000, then alternative B is the best.
- Finally, if the production is greater than 5000 units,
then alternative C is the best.
9-51 Newmann
A newspaper is considering purchasing locked vending machines
to replace open newspaper racks for the sale of its newspapers in
the downtown area. The newspaper vending machines cost $45
each. It is expected that the annual revenue from selling the
same quantity of newspapers will increase $12 per vending
machine. The useful life of the vending machine is unknown.
(a) To determine the sensitivity of rate of return to useful life,
prepare a graph for rate of return versus useful life for lives
up to 8 years.
(b) If the newspaper requires a 12% rate of return, what
minimum useful life must it obtain from the vending
machines?
(c) What would be the rate of return if the vending machines
were to last indefinitely?